Capital structure Flashcards
What is the capital structure of a firm?
The mix of debt and equity within a firm’s finances
Modigliani and miller showed what and when?
In their 1958 paper, Modigliani and miller showed that in perfect capital markets, capital structure is not related to firm value.
What were the MM theorem assumptions?
- Perfect capital markets:
- No taxation costs
- No bankruptcy costs
- No agency/information problem - No arbitrage opportunities
Why did MM state that firm value isn’t related to capital structure?
Because a firm’s value is determined by the cash flows their assets will generate, not how the cash flows are financed.
Why does WACC remain constant under PCM?
WACC remains constant because as value of debt rises, the increased risk to equity holders means higher RE, and this offsets the lowered cost of capital offered by cheap debt.
What is a formula for RE in terms of RA?
RE = RA + (D/E)(RA-RD)
Why and when did MM suggest optimal capital structure is 100% debt?
MM suggested in 1963 that OCS is 100% debt because a levered firm pays less in taxes than an unlevered firm, due to interest payments on debt being tax deductible.
What is the formula for firm value of a levered and unlevered firm? (Non perpetual cash flows)
VU = EBIT(1-Tc) VL= EBIT1-tc) + (RD*D*Tc)
What is the unlevered and levered firm value under perpetual cash flows?
VU = EBIT(1-tc)/RA VL = EBIT(1-tc)/RA + (RD*D*Tc)/Rd
What is the formula for RE with corporate taxes?
RE = RA + (D/E)(RA-RD)(1-Tc)
What is the disadvantage of debt?
The primary disadvantage of debt is bankruptcy. If a firm cannot pay it’s debts, creditors can force the company to stop operations and sell assets to recover their capital.
Second disadvantage is that debt repayments are a legal obligation, whereas dividends are essentially optional.
What are the direct and indirect costs of bankruptcy?
Direct = Legal and admin costs, accountants, lawyers etc Indirect = Lost sales, suppliers distrusting you, key staff leaving, higher interest on loans/below investment grade debt.
What are 3 thing shareholders can do when at conflict with debtholders?
- Take large risks (Higher expected value projects even though risk is higher)
- Underinvestment (Invest less as cash flows first go to debtholders)
- Milk the property (Pay out extra dividends in presence of high debt, leaving less for debtholders)
What is Tradeoff theory?
Firms trade off tax benefits of debt with bankruptcy costs and agency costs associated with higher debt.
What is the optimal debt point?
The market value of a firm increase with debt up until the optimal debt point, and after this point the bankruptcy and agency costs associated with higher debt outweigh the tax benefits. WACC increases after this point.
